The new 800 lb gorillas

May 21st saw yet another story on China, but with a difference: this one has enough significance to reshape global financial markets. The country announced a $3 billion investment in Blackstone, one of the world’s premier private equity firms. Behind this is another $1.2 trillion of governmental reserves—like the trickle from the sluice gates of a gigantic dam that could wash away many vessels in financial waters. Market players will now look fearfully over their shoulders as they determine demand-and-supply for global assets, wondering how economic nationalism will play out.

China joins a growing tribe of countries converting their foreign exchange reserves into strategic investments called Sovereign Wealth Funds (SWFs). While experts are divided on the long-run implications of SWFs, there is no question that they will be the biggest force on the markets for the next few decades.

I want to talk about two specific aspects of SWFs, one in this piece, the second in my next column. But, first, a quick primer. To begin with, their size: $2.5 trillion, projected to go up to $12 trillion by 2015. SWFs are already larger than the global hedge fund industry. By 2011, they will exceed the total foreign reserves of countries. SWFs hold over 40% of total cross border flows already, and are equal to total global FDI and portfolio investments.

Countries with SWFs include the UAE, Kuwait, Norway and others, with Singapore a rare non-commodity driven player. Stephen Jen of Morgan Stanley—one of two prolific writers on SWFs-states, “Currently, SWFs from oil and gas exports account for two-thirds of the total, with the rest (from) Asian exporters. The share of oil-centred SWFs is expected to decline, reaching 50% by 2015.”

How important are SWFs to their countries? Andrew Rozanov of State Street—the other—says: “One example may best illustrate the point—Kuwait managed to regain its independence and rebuild the country after the Iraqi invasion in large part thanks to the large pool of assets accumulated and managed by KIA. This lesson is not lost on Asian sovereign wealth managers.”

The SWF phenomenon should not come as a surprise: after all, why should countries continue to hold low-yielding US government bonds, in amounts far exceeding prudent norms? Like Singapore’s Temasek Investments, several countries had established strategic fund management arms while retaining liquidity. China’s move pushes the needle one notch further: investing in an independent professional investor.

However, SWFs need not be innocent excess funds of a country being deployed for superior returns—they can be the spearhead of economic protectionist forces, taking strategic stakes in natural resources, intellectual property or key industries. SWFs could replace war and occupation to access resources, and get it done through legitimate market channels, greased and facilitated by intermediaries like private equity firms. Suddenly, China’s investment in Blackstone seems not just an act of outsourcing core competence, but of purchasing very credible camouflage.

As the debate on SWFs begins, there will be much ideological criticism: one more reason to indict market forces and greedy capitalists. However, the real issue is the regulatory architecture for these fund flows. SWFs have exploded so quickly on the global financial community that checks-and-balances are almost non-existent. Current financial regulations on these cross-border flows are like wire-meshes to protect against the flu. Most SWFs are in weak democracies, with poor governance systems even within their own borders. With the exception of Norway, no SWF has any publicly available information on their investments. Normally, regulations are administered by governments to check private excesses. With SWFs, countries have themselves become market players. So, now, who will guard the guards?

We need a new set of global regulations, designed by governments and monitored by agencies that are yet to be set up. Almost ten years ago, in the midst of the last financial crisis, Gordon Brown said, “We need a new co-ordinating mechanism to ensure proper standards (for) international capital flows.” Aiming to define how “global markets can work in the public interest”, he suggested the concept of a “new permanent Standing Committee for Global Financial Regulation, so that the necessary international standards for financial regulation and supervision are put in place.”

With SWFs, the need for redefining global financial regulations couldn’t be more acute. After all, there is a very fine line between a free market and a free-for-all market.

Ramesh Ramanathan is co-founder, Janaagraha. Mobius Strip, much like its mathematical origins, blurs boundaries. It is about the continuum between the state, market and our society. We welcome your comments at mobiusstrip@livemint.com